Sunday, August 12, 2007

Whenever i hear the phrase "off balance sheet" vehicles "Enron" and other accounting scandals are coming to my mind. It is often only a matter of time until the ticking time bomb is taking its toll. In the case of the German IKB and probably the Sachsen LB i think the board that has the oversight is just too incompetent to realize what is and was going on. On top of this it is clear that the Bafin ( banking oversight ) has done a lousy job and didn´t know anything about the immense risk that small German banks were taking. Maybe they should order this excellent artwork from the NYT to understand what kind of junk they have often as AAA in their books..... ( hat tip to Pancho Villa and Calculated Risk

Policymakers and investors have been obsessed in recent years about the potential for a hedge fund collapse to spread financial panic. But it seems one of the biggest threats to stability is coming from the age-old risk of short-term borrowing to fund investments in illiquid long-term products.

In a corner of the market few people knew existed, regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes de­signed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments.

These have proliferated in recent years and control assets worth hundreds of billions of dollars. Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits. > Here the German conduits / Übersicht der deutschen Conduits

They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet.

It seems they have played a key role in last week’s liquidity crunch.

“We are in the middle of a mini-crisis in the commercial paper market, at least half of which is related to the SIV conduits,” says Robert McAdie, global head of credit strategy at Barclays.

These programmes typically invest in credit market instruments, such as US subprime mortgage-backed bonds and collateralised debt obligations. These assets tend to be the highly rated, supposedly safe versions of such debt, but in the recent fear-driven turmoil have shown just how illiquid and hard to value theycan be.

The profit for those who run such programmes comes from the fact that the assets pay fairly high yields, while the conduits and SIVs fund their purchases with short-term borrowings in which interest and principal payments are backed by financial assets that are deemed to have stable cash flow. Collectively this so-called “asset-backed commercial paper” – or ABCP – lasts for anything between a few days and a few months before needing to be refunded.

The problem could be thrown into relief when billions of dollars of ABCP mature today and on Wednesday, with great un­certainty as to whether this can be refinanced.

Everything in this market depends on investors in the ABCP market maintaining their faith in the programmes and the assets they hold. With the current rush for the exits in many structured credit markets, this faith has been evaporating wholesale. No investors are sure exactly what assets SIVs and conduits are holding, or how damaged those holdings might be.

While many non-SIV funds – such as those run by BNP, Axa and others that have hit trouble recently – were able to stop investors pulling their cash out, SIVs and conduits who see their funding expire on a regular basis have no such luxury.

In the case of a blip in the market, SIVs and conduits are supported by liquidity facilities from highly rated, mainstream banks. This means banks must step in to provide finance if the SIV cannot raise commercial paper in the normal way, unless the SIVs’ assets suffer significant ratings downgrades. Typically, the credit line provided by the sponsoring bank and a group of others in a syndicate must cover 100 per cent of outstanding commercial paper.

These funding lines have rarely been drawn in recent years, because liquidity has been abundant in the ABCP market as almost everywhere else in the financial world. As recently as mid-June, the European commercial paper market was seeing records levels of issuance.

However, what sparked last week’s turmoil – and the dramatic intervention by central banks – was a pernicious chain of events. As it became apparent this summer that the US subprime problems were worsening and infecting a broader range of structured products, some investors in the ABCP market started to worry about whether SIVs were also sitting on losses.

The rush to sell structured products by hedge funds facing redemptions and other investors meant those market values that could be ascertained were being marked down heavily. As a result, by mid-July some investors decided to stop buying ABCP paper from SIVs suspected of subprime exposure.

The German bank IKB was an early victim. Another victim could be the Landesbank Sachsen. Like many local peers, it had a conduit – called Rhineland Funding – which had ex­panded rapidly and had almost €20bn ($27.3bn, £13.5bn) worth of outstanding commercial paper in the markets in July. In mid-July, ABCP investors refused to roll over some of these notes.

Rhineland asked IKB to provide a credit line, as the rules of SIVs require. But it appears the German bank did not have enough cash to meet this request and was unable to liquidate enough assets to plug the gap. This threatened to trigger IKB’s collapse, until KFW, the state-owned German bank, stepped in and offeredan €8bn credit facility.

German officials hoped this action would stop growing panic in the sector. But it may have had the reverse effect: investors started to shun almost all commercial paper issued by SIVs.

“This is an environment where there has been a big loss in confidence and nobody is distinguishing between apples and oranges,” notes Mr McAdie.

By early August, the problems in the ABCP market had become so serious that some European banks were preparing for additional calls on credit lines to SIVs. But the banks are also grappling with a backlog of unsold leveraged loans, which is placing additional pressure on their balance sheets.

So early this month some European banks – and a few US institutions as well – quietly started trying to raise new credit lines themselves. That, however, triggered additional alarm, as rumours spread about the potential losses at SIVs – on top of problems in other corners of the financial world.

Consequently, by the middle of last week, some banks started shutting credit lines to a sweeping list of institutions. “Commercial paper is now being funded on an overnight basis. The banks will not roll paper for three months,” says Dominic Konstam, head of interest rate strategy for Credit Suisse. ....

Policymakers hope that some of this panic will dissipate this week following the massive emergency injections of liquidity by the ECB and US Federal Reserve. And indeed, by the end of last week, borrowing rates were stabilising. There were signs vulture funds were circling, ready to pick up ABCP paper at bargain prices.

“What some people are hoping is that the bottom fishers will appear and help the market self-correct,” says one big ABCP issuer.

However, nobody close to this sector expects to see a quick solution soon. Commercial paper interest rates have not yet fallen, irrespective of central banks’ actions. In New York on Friday, they closed at their highest level for six years.

There is deep uncertain­ty about what the central banks will do next – making ABCP players even more reluc­tant to start issuing and trading again. “Nobody is going to handle commercial paper if they think the Fed could be about to cut rates or do some­thing else completely unexpected overnight,” explains one.

However, the third, most pernicious problem is that it is becoming clear central banks cannot resolve the biggest problem – a lack of clarity about valuations in structured credit markets and the almost complete loss of confidence that is infecting even the biggest and most diversified of conduit-type programmes.

"So-called structured investment vehicles, which hold $370 billion of assets.....11.5 percent of SIV holdings are in U.S. residential mortgage securities, Moody's says, while another 11 percent are so-called collateralized debt obligations....SIV versions of CDOs, called SIV-lites, and structured loan vehicles, SLVs, represent the ``hybrid'' part of the SIV market, with another $25 billion in assets, according to Moody's. SIV- lites are about 96 percent invested in U.S. residential bonds."

Nice Timing..... Another vehicle that has only the function to increase leverage.....

A traditional SIV will generally offer investors 12 to 16 times leverage, but SIV-Lites have equity leverage of 40 to 70 times, depending on the collateral.

And it should be no surprise that S&P is as always overly confident

"Unlike a CDO, an SIV is an ongoing open-ended vehicle; it can change size and re-finance. "SIVs can increase or decrease leverage on a daily basis," says Cian Chandler, European structured finance analyst at Standard & Poor's in London"

"Securities arbitrage conduits invest almost exclusively in AAAasset-backed securities (more than 97% of their assets) and as such,together with SIVs, are by far the largest single buyer group for thisasset class. However, ABS is also the largest asset class forhybrid/multi-seller conduits, accounting for around 34% ofholdings.

If we take Moody’s Investors Service’s number of $488 billionin assets held by the European ABCP conduits at year-end 2006,the above share would translate to a total ABS holding of morethan $300 billion of the European conduits alone. This equates toabout half of 2006 ABS issuance in Europe, and one-eighth ofglobal ABS issuance in 2006.

Furthermore, the multi-seller and hybrid conduits investoutright in assets typically found in ABS term structures, such asmortgages, consumer and commercial loans, among others, andas such compete with term structures for assets, or enable thestructuring of large-volume term ABS deals by way of providingbridge finance in the ramp-up stage. The ABCP conduits are thusan inseparably interwoven part of the global ABS market, andmany of the structures focusing on the ABS market have beengrowing fastest. According to a Standard & Poor’s report on thesecond half of 2006, both credit arbitrage and the newer repoconduits are leading this trend. The top four arbitrage conduitshave been growing steadily year-on-year—Grampian (13.5%),Amstel (10.6%), Solitaire (74.5%) and Ormond Quay (87.8%).

Using Moody’s ABCP query, which is based on investor reportsfor the various vehicles, the asset make-up of the arbitrage conduitslargely reflects the wider ABS market, with the biggest asset classessuch as residential mortgage-backed securities, collateralized loanand debt obligations, commercial mortgage-backed securities andother consumer receivables featuring prominently. Compared to a“neutral” market weighting, we find that the share of “higheryielding” is increased, notably CLO and CDO paper, while RMBSis somewhat underrepresented.

Typically, ABCP issuance matches the funding currency to theunderlying assets’ currency. Thus, a large part of CP issued byEuropean conduits is typically denominated in U.S. dollars.Moreover, and sometimes confusingly, the European conduits issueboth in the European CP market, at a share of about 48%, and theU.S. CP market (about half of issuance) with a small share taken bythe French ABBT.

LIQUIDITY FACILITIESABCP programs typically benefit from liquidity facilities equal tothe amount of commercial paper outstanding. The liquidity can bedrawn against non-defaulted securities to repay CP investors if theprogram is unable to reissue or roll maturing commercial paper. Itis important to note that the sponsor of an ABCP programme doesnot guarantee its liabilities.

Key credit factors for investors in an ABCP programmetherefore include the strength of the bank providing liquidityline(s) to the program, assets in the portfolio, rules governing whenCP can be issued and when liquidity lines must be drawn, and theoperational skills of the sponsor in ensuring that all of the variouslimits are complied with.

EXTENDIBLE CP AND DYNAMIC CREDIT ENHANCEMENTAnother route to reduce the need for liquidity (and thus for capitalunder Basel II) is the use of: a) extendible commercial paper orextendible commercial notes, and b) dynamic credit enhancement.ECN are almost identical to traditional CP, with one majordifference: the issuer can choose to extend the maturity date of theCP beyond the initial maturity date of one to 270 days fromissuance. Extendible CP allows an issuer to cover the liquidity riskof a failed or potentially failed remarketing of its paper and avoiddefault by exercising its option to extend the maturity date, thusprecluding a need for liquidity. Extendible CP is rated the same astraditional CP.

The rating does not address the likelihood of extension, onlypayment in accordance with terms. An extension does notconstitute a default of the paper. Moody’s reports that four EMEAconduits have ECN outstanding, totalling $8.8 billion as ofDecember 2006. A further 10 conduits have the ability to do so.

Dynamic credit enhancement is a central feature found in SIVsand requires a sophisticated risk management and modellinginfrastructure. Recently, a number of conduits have adopted ways toemploy CDO and SIV technologies that allows them to size creditenhancement on a dynamic basis according to the prevailing riskprofile of the asset portfolio. With the implementation of Basel II,there will surely be a trend of converging technologies between thecredit arbitrage vehicle and SIVs.

TYPICAL STRUCTURAL FEATURESThe investment manager selects the assets for the vehicle andmanages the CP programs on an ongoing basis. It typically also hascontractual obligations to act as issuing and paying agent, accountbank, custodian, cash administrator and liquidity agent.The issuer is a bankruptcy-remote entity incorporated underthe laws of a tax friendly jurisdiction, often Jersey for European CP,or Delaware or Cayman Islands for U.S. CP. As the norm with abankruptcy remote SPV, all directors have to be independent of thesponsor, and the vehicle’s shares are held on trust for CP investors.

CREDIT ENHANCEMENTCredit enhancement is often provided by a letter of credit providedby the sponsoring bank that provides protection against anydefaults on assets, typically sized to provide a buffer above therating agencies’ minimum requirements. Repayment of anydrawings on the LOC would be subordinated to payments to CPinvestors. In addition, excess spread and the entire asset portfolio isavailable to offset losses regardless of the asset holding vehicle inwhich the assets are kept (as often two vehicles are in operation toprovide for U.S. and European CP issuance).

If the rating of certain assets should fall below specific thresholdsoutlined in the credit enhancement criteria, the manager of thevehicle can sell these assets, provided there are sufficient profits tocover any shortfall. Alternatively, an amount of credit enhancementwould be required commensurate with the associated credit risk ofthese assets. If the manager should fail to either provide sufficientcredit enhancement or sell the downgraded assets, this wouldultimately constitute a wind-down trigger and the vehicle would notbe allowed to further issue CP notes.

LIQUIDITY SUPPORTA liquidity facility by a top-rated bank (i.e., P-1/A-1+/F1+) issized to the amount of outstanding CP notes. This liquiditysupport will be drawn upon at maturity to repay outstanding CPif new CP cannot be issued, e.g. a disruption of the European CPmarkets or a deterioration of the conduit’s asset pool. Generally,the liquidity line can be drawn for an amount up to the currentvalue of the asset pool (excluding defaulted assets). Current valueis basically defined as an asset’s book value, i.e. the amortizedpurchase price (including accrued unpaid interest and anyhedging gains or losses).

INVESTMENT GUIDELINESTo ensure that the asset pool maintains a high credit quality,arbitrage conduits are obliged to follow specified investmentcriteria. Among others, in many conduits the assets must be rated atleast Aa3/AA- by Moody’s and S&P (i.e. no single ratings), and noton watch or review for downgrade at the time of acquisition. Theymust also comply with various rating limits on an ongoing basis,and must be purchased at a discount or at par unless theprepayment risk is hedged. The vehicle can invest only in ABS orMBS, debenture or similar secured product or sovereign debt,unless written approval is obtained from the rating agencies. Itcannot be an IO strip, interest or principal only, or convertible intoequity, and it must be located in an OECD country anddenominated in euros, British pounds or U.S. dollars.Some of the “pure ABS” conduits feature a prohibitionfrom investing in corporate debt securities and mezzanineABS bonds. This is designed to minimise the downgrade riskin the asset portfolio as AAA ABS securities have historicallyexhibited much lower downgrade rates than corporatesecurities or mezzanine ABS."

Nevertheless, the lack of transparency for the new esoteric instruments, such as collateralized debt obligations and collateralized loan obligations, has exacerbated the current nervousness because nobody knows what they're worth, he also notes.

In that, it appears some of the problem lies with asset-backed commercial paper "conduits" and so-called structured investment vehicles. These ABCP conduits and SIVs are used to fund the purchase of assets such as trade receivables, auto loans, credit cards, whole mortgage loans, as well as securities such as corporate debt, residential mortgage-backed securities and CDOs, according to a Bear Stearns report.

The ABCP conduits and the SIVs then are able to issue high-grade commercial paper to finance these assets, which are less the prime quality. ABCP now comprises over half the $2 trillion-plus commercial paper market, up from 20% in 1998, according to MacroMavens' Stephanie Pomboy. And, money market funds own 27% of all CP outstanding, she also notes.

According to the Bear report, some $38 billion-$43 billion RMBS and CDOs could be liquidated from ABCP conduits. Got that? In other words, a load of these assets is backing ABCP and may have to be sold into a less than receptive market.

In the case of the German IKB and probably the Sachsen LB i think the board that has the oversight is just too incompetent to realize what is and was going on.

This may be true where you live, but in my country there is a vast realm of corruption in high places. It is pervasive. Nothing happens by accident, they muck things up on purpose, more opportunity for profit that way.